Begin with the assumption that one of the primary purposes of closely held and family businesses is to create wealth for their owners. Despite this driving purpose, the owners and managers of many private businesses engage in strategies that actually destroy wealth for their owners.

Why would I say that?  Quite often, owners focus on managing the return on equity (ROE) of their businesses.  There is nothing wrong with that, of course.  But boards of directors of private companies should also be focused on managing realized shareholder returns.  George Isaac said it well in a recent article for cnbc.com:

Unlike public companies, private companies don’t worry about daily stock prices. In public companies, shareholders can realize their value by selling their stock in the market. Private company shareholders don’t have this option.

Until cash or other assets are distributed and “realized,” private company shareholder returns are zero—shareholders have nothing more than an unrealized stock gain, which is exposed to all the associated business and financial risks of owning an illiquid stock. Given this difference, private companies should expand their focus from solely creating shareholder value to include strategies for realizing value for their shareholders.

The inward focus at many private companies, i.e., focusing on the company itself and not on realized returns to shareholders, leads to a number of what Isaac calls “wealth evaporation” factors.  In the following discussion, I’ll use his factors and put my own spin on them.  Read what Isaac has to say here.

1. Time value of money.  A dollar today is worth more than a dollar tomorrow.  That’s a basic present value concept.  A dollar of realized return from one’s private business today is worth more than a dollar tomorrow.  This is particularly true when dollars are readily available for harvesting from a business.  Delay can be very costly, indeed.
2. Working capital conservatism.  This form of conservatism manifests itself in two ways.  First, any lack of aggressiveness in managing inventory and accounts receivable, or in accumulating cash, has a dampening impact on owner returns.  The second form of working capital conservatism may result from debt aversion.  Working capital lines of credit are cheap in today’s environment.  Said another way, self-financing of working capital can be expensive to owners if expected returns on distributions exceeds the cost of debt in the business.
3. The debt hawk.  The cost of debt, particularly in today’s environment, is less than the cost of equity.  Good financial management may call for maintaining a prudent level of debt.  Boards of directors that are focused on corporate return on equity realize this fact and utilize a reasonable amount of debt in the capital structure.  If using an appropriate amount of debt enhances a company’s ROE, not using that amount of debt decreases ROE – and the opportunity to realize shareholder returns in the form of distributions.
4. Excessive cash controls.  Managements that are not focused on generating cash and providing returns to shareholders may destroy wealth by accumulating assets, inventories, cash and other stuff on the balance sheet.  This factor is a sister to number two above, working capital conservatism.  Read my last post, Get Excess Cash Off Your Balance Sheet.
5. Tail-risky business.  Too many business owners seem to be waiting for that pay day, someday, maybe, that they hope to achieve when they sell their businesses.  Deferring shareholder returns, potentially indefinitely, is a risky strategy.  Business owners do not control industry factors, interest rates, the availability of financing, or the pricing of businesses, all of which can adversely impact business and shareholder value in any short-run period of time.  For example, consider that there were likely a large number of business owners who might have been planning to realize liquidity from selling their businesses in the 2008-2009 period of the Great Recession.

Private businesses can be wealth generating machines.  If a business is in a growth phase during which reinvestment opportunities generate great returns, then it is entirely appropriate to focus on reinvestment in a business.  However, many companies reach thresholds where growth opportunities diminish somewhat or a lot. What should happen then?  Try these suggestions from my book, Unlocking Private Company Wealth.

1. Focus on the rate of return at the corporate level.  This can be through prudent financial management, good operational management, and focus on appropriate growth opportunities.
2. Focus on current opportunities to provide returns to shareholders.  This may require a mindset shift for many business owners, but it is to their advantage.  There are a number of ways to do this, but it begins with the idea that businesses are wealth generating vehicles for owners, who should examine all reasonable means of obtaining wealth, liquidity and diversification from a business while they own it, and not just at some uncertain future liquidity event.
3. Return excess assets to owners.  One way to provide current returns is to make dividends or distributions of excess assets on the balance sheet.  To read more about this, click here.
4. Consider a regular dividend/distribution policy.  In addition to providing current returns to shareholders, the implementation of a regular dividend policy may create better management focus on financial and operational matters.  No one wants to be the bearer of news that a dividend must be cut or eliminated because of poor management decisions!  Dividend policy is important for private companies.
5. Consider a leveraged dividend recapitalization.  Some companies are excellent candidates to borrow reasonable amounts and pay special dividends with the leveraged funds.  This sort of recapitalization can provide significant liquidity for owners and risk sharing, as well.  With a bank or other capital provider providing funds at relatively low cost, return on equity will be enhanced and future owner returns should be greater.

Implementation of one or more of the above strategies will dampen any tendency for private companies to engage in wealth destruction.  So let’s focus on wealth building, creating liquidity and diversification opportunities, and current realized shareholder returns.

Comment on this post below and join the conversation.  If you would like to talk to me about ownership and management transition issues, or any issues related to business valuation, please do email me (mercerc@mercercapital.com) or call me (901-685-2120).  I would be pleased to talk with you in confidence and at no obligation to you.

Until next time, be well!

Chris